James Solloway, Chief Market Strategist, Investment Management Unit, provides a mid-year economic outlook.
Despite mounting infections and deaths from the COVID-19 pandemic — as well as the unprecedented stoppage of global economic activity — stock markets around the world managed to mount a resounding comeback during the second quarter.
The MSCI USA Index soared to finish the second quarter 41% higher than its March 23 low. It was down just 2.2% for the first half of the year. While the MSCI World ex USA and MSCI Emerging Markets Indexes continued to lag their U.S. counterpart, they each finished the second quarter remarkably higher than their respective March lows; for the first half of the year, they both fell by approximately 10% in U.S. dollar terms.
The huge rebound in equity prices was particularly stunning given the bleak economic backdrop. Investors seem to be ignoring the possibility that, even as recovery gets under way, it may be a long time before most companies achieve previous levels of profitability.
The after-tax profit margins of U.S. domestic businesses were already on a declining trend before the onset of the virus and shelter-in-place orders.
We expect U.S. earnings data will show that profit margins collapsed during the second-quarter—yet SEI also anticipates a rebound to closely follow as economic activity makes a comeback. Nevertheless, margins are likely to remain well below their previous peaks as long as the coronavirus is a severe health threat.
The extraordinary lockdowns across the world during March and April necessitated fiscal measures that were unparalleled in terms of both scope and implementation speed. The economic result has been a tsunami of red-inked data.
In the U.S., the Congressional Budget Office projects the federal budget deficit will reach nearly 18% of GDP during 2020 and improve to only 10% of GDP during 2021. Debt relative to GDP is expected to rise to 108% by the end of the 2021 fiscal year (20 percentage points above the CBO’s March estimate); by comparison, debt relative to GDP was 79% at the end of fiscal year 2019.
These are unsettling numbers. Many investors wonder whether such a surge in government debt might provoke another economic crisis after the pandemic runs its course. We don’t think that it will.
The U.S. has a large, dynamic economy and deep capital markets. The buoyancy of the U.S. dollar versus other currencies remains impressive, although we do expect it to decline overtime. If investors were truly concerned about the long-run fiscal viability of the U.S., the value of its currency would be falling more convincingly and long-term interest rates would be going up rather than down.
It’s been said many times that bull markets climb a wall of worry. Maybe now they must learn to swim through waves of worry, including:
Whether the spread of COVID-19 will force another round of extensive lockdowns and shelter-in-place orders that could lead to a double-dip recession.
As economies struggle to get back on their feet, the political consensus seen in March and April regarding the way forward might begin to break down.
Even if most countries manage to avoid a disruptive second wave of the virus, few economies are likely to rebound fully to pre-pandemic levels. Recovery should take at least a year, and likely longer.
Most companies will face higher costs and increased inefficiencies. Taxes will almost certainly rise in the years ahead across many economies. As government aid programs end, bankruptcies and defaults are expected to climb.
These various concerns will ebb and flow, implying that financial markets will probably remain volatile in the months ahead. Of course, volatile markets are the true test of a manager’s resolve, and we are pleased to say that our investment managers have stayed true to their strategies. Radical changes to investment process are not something that we pursue or expect to see from our managers. Pandemics or not, we understand that investment opportunities always harbor volatility and we are prepared to manage through this period of high uncertainty.
Glossary of Financial Terms:
Bull market: A bull market refers to a market environment In which prices are generally rising (or are expected to do so) and investor confidence is high.
The MSCI Emerging Markets Index is a free float-adjusted market-capitalization-weighted index designed to measure the performance of global emerging-market equities.
The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the U.S. market. The Index covers approximately 85% of the free float-adjusted market capitalization in the U.S.
The MSCI World ex-USA Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets, excluding the U.S. market.
The S&P 500 Index is a capitalization-weighted index made up of 500 widely held U.S. large-cap companies.
The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the Strategies or any security in particular, nor an opinion regarding the appropriateness of any investment. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. All information as of June 30, 2020.
There are risks involved with investing, including loss of principal. Diversification may not protect against market risk. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.
Index returns are for illustrative purposes only, and do not represent actual account performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index.
Information provided in the U.S. by SEI Investments Management Corporation.